•Adding the commodity price to the VAR has a significant impact on CPI in relationto the previous estimate. The profile now looks more reasonable, i.e. inflation fallsin response to tighter monetary policy.

•This could be due to commodities weighting in the CPI index. Tighter monetarypolicy seems to have a negative relationship with commodity prices. Thus, thisshould have a downward influence on inflation.

•The terms of trade defined as price of domestically produced goods minusimported goods, sees a deterioration, with a full recovery taking some time. Thiswould be consistent with the FX move in the previous question.

•Net trade also deteriorates as foreign imports become more expensive, again thisis consistent with the move on FX in the previous question

Question 1 (C3)–

FFR impact on the UK output

•For UK output, the IRF of a positive shock to FFR is initially positive and thennegative.

•

Expenditure switching, defined as switching to home produced goods as foreigngoods become more expensive, does not seem to occur here. If this were thecase, we would expect to see UK output increase as consumption of home goodsrises.

Question 1 (D)–

is there evidence of LCP?

•The results of sections C(1-3) suggest the data does support the theory of localcurrency pricing.

•The response of the exchange rate, from a shock to the FFR is positive. Theexchange rates impact on other variables is how we determine if LCP is present.

•The evidence on UK net trade which saw a decrease when the exchange rateincreased would support the idea the idea that LCP is present. This is becausenet trade fell. Imports did not fall as they became more expensive, and exports didnot increase as they became cheaper.

•The evidence from the impact of FFR on UK output would also support LCP. IfLCP was not present, then output would increase as the exchange rate increased.i.e. there would be evidence of expenditure switching.